Abstract

This paper examines the impact of Environmental, Social, and Governance (ESG) rating on a firm’s debt structure. We find that optimal (market and book) leverage ratios and information asymmetry are reduced when firms become ESG rated. More importantly, ESG rated firms redistribute their financing sources from public debt (bonds issuing) to private debt (bank loans). These results are attributed to the incentive of ESG rated firms to avoid debt-overhang and underinvestment issues and to the fact that the ESG rating conveys valuable information to lenders leading to better access towards more internal sources of financing, such as bank loans over debt issuing. We further find that the substitution effect is more pronounced for firms with high financial pressure, low growth opportunities and specialized assets. Finally, these results remain valid under various robustness and endogeneity tests.  

Abstract

This paper examines the combined effects of Economic Policy Uncertainty (EPU) and Environmental, Social, and Governance (ESG) ratings on the level of leverage and its speed of adjustment (SOA). We find that both the EPU and ESG ratings are negatively associated with leverage when assessed separately. However, when EPU and ESG ratings are combined, we show that ESG ratings mitigate the detrimental impact of EPU on leverage. Our results also indicate that higher EPU levels force firms to increase their speed of adjustment due to tighter financing requirements, while ESG ratings overcome that issue and enable firms to maintain lower SOA. These results are robust to various robustness checks and are mainly driven by environmental and social factors. Our paper contributes to the growing ESG literature by showing that ESG ratings can alleviate the adverse effects of EPU on leverage and SOA.